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Chapter 20: Business Entities

20.1 Business Entities Generally

Business entities are organizations formed and organized for the purpose of carrying out a particular business or trade. Such organizations have been formed for thousands of years, and in almost every civilization throughout history. Business entities serve the purpose of pooling resources and allocating them in an efficient manner, as well as providing their owners with certain legal protection. In the United States, business entities are, for the most part, governed by state law, although they are subject to certain federal regulations and some entities (such as national banking associations) are chartered by the federal government. In recent years, however, there has been a push for a federalization of business entity law (a push that is vehemently opposed by states that have become havens for business entity formation), and it is likely that this issue will continue to be debated for some time.

20.2 Key Concepts

Agency. Agency law is the branch of law that determines when one party (the agent) may act on behalf of another (the principal). Agents are given authority to act on behalf of their principals; such authority may be actual (where the principal’s words or behavior cause the agent to reasonably believe that he has been authorized to act), apparent or ostensible (where the principal’s words or actions would cause a reasonable third party to believe that the agent was authorized to act), implied (authority to perform acts reasonably necessary to carry out an agent’s expressly authorized duties), or inherent (where authority is assumed because of an agent’s position with relation to his principal, as is the case with partners in a partnership, who are each other’s agents). An agent may have authority to bind his principal to a contract even if the principal is unaware of its terms. An agent who acts without actual authority may still bind his principal to an agreement with a third party if he had apparent authority from the standpoint of the third party, but the agent in such a situation would be liable to his principal for any damage resulting.[1] A principal may also be liable to third parties for tort caused by tortious behavior of his agent, so long as the tort was committed within the scope of the agent’s duties (including torts committed while on a brief detour, but not on a more extensive frolic). Employees are usually agents of their companies for at least some purposes, but even independent contractors can be considered agents if those who hire them maintain significant control over the manner in which they do their work.[2] For a detailed discussion of the legal distinction between employees and independent contractors, see chapter 17.

Fiduciary duties. Agents owe fiduciary duties to their principals. Likewise, partners owe such duties to one another and the directors, managers, and other controllers of a business entity owe such duties to the company’s owners.[3] The nature and scope of fiduciary duties is more or less uniform nationwide, though local variations may exist. Generally, the fiduciary duties include a duty of care (the duty to manage the principal’s affairs with the same care one would take with one’s own affairs) and the duty of loyalty (the duty to act in the best interests of the principal and not in a self-interested manner).[4] These duties are often said to encompass a duty of good faith and a duty of disclosure (when, for example, the agent has a conflict of interests). In some situations fiduciary duties may be limited or substantially eliminated by contract (although most states prohibit corporations from doing so, other types of business entities often are authorized to do so). As with contracts, however, the duty of good faith and fair dealing is a minimal requirement that can never be waived.

Domicile. The state, territory, or other jurisdiction in which a business entity is formed is called a domicile. Business entities need not be based in their domiciles, or in most cases, have any operations whatsoever there. Thus, due to its favorable business entity laws, low taxes, and efficient and knowledgeable courts, many entities are domiciled in the State of Delaware, even if they have no offices and carry out no business in that state. (Many others, for the same reason, domicile in Nevada or South Dakota.) Most states require that all entities domiciled within them pay an annual fee or franchise tax and maintain a registered agent within the state, who is authorized to receive service of process of court proceedings against the entity (and who may charge a substantial fee for these services).

Charter / operating agreement. A business entity is normally formed by filing a charter, a certificate setting forth certain required information, with an appropriate government body (although some types of entities, such as general partnerships, are not subject to this requirement). In some states the charter is referred to as a “Certificate of Formation,” “Certificate of Incorporation,” or by a similar name. All business entities are governed in accordance with some type of operating agreement (called bylaws in the case of a corporation). The operating agreement typically sets out the purpose of the company and the powers, rights, and duties of its owners and operators.

Equity. Equity or ownership interest refers to the ownership of a business entity, which is often separate from the entity’s management. Owners of a company (such as corporate shareholders or partners in a partnership) may, depending on the type of entity and their own preference, divide the company’s equity into shares of stock or uncertificated interests; some companies are instead divided into percentage shares. Even when they have no right to directly manage the affairs of a company, owners or equity holders will have certain rights, such as the right to elect or appoint managers or directors or the right to inspect the company’s books and records.[5]

Management. A company is managed according to the governing law and the company’s organizational agreement. Management is usually in the hand of directors (in the case of a corporation), partners (in the case of a partnership), or managers (in the case of a limited liability company). Managers of a business entity need not be equity holders, but they may be. Managers often can delegate their powers to officers (such as a president or CEO) to carry out the day-to-day operations of the company.[6]

Limited liability. Some types of business entities (most famously, corporations) offer limited liability to their managers, owners, and officers. That is, under most circumstances such parties will have no personal liability for debts incurred (through tort or contract) by the business entity. A “corporate veil”[7] is said to separate the assets of the owners and managers from those of the company. This protection is not absolute, however, and courts will not allow it to protect the perpetrators of a fraud, or where there is no real distinction between a corporation and its shareholder (or director). In such cases the courts may pierce the corporate veil and allow creditors to collect from the personal assets of individuals or entities usually protected by limited liability.[8]

Among the factors considered by courts to determine whether veil-piercing is appropriate are (1) whether it has independent reasons for existence; (2) that it sole purpose is to provide the means of doing the bidding of the individual stockholder; (3) that it was established to perpetrate a fraud; (4) that it is undercapitalized and underinsured given the nature of its business activities; (5) that it holds itself out to the public as the same entity as its parent or other affiliate; and (6) that its managers do not observe proper corporate formalities. [9] In recent years courts have shifted their focus from corporate formalities and in many states courts will only pierce the veil in cases of fraud or similar wrongdoing.[10]

Business judgment rule. The business judgment rule, articulated most famously by the Delaware Supreme Court and nearly universally accepted, states that courts will not interfere with the management of a company unless those seeking to challenge a management decision can make a preliminary, or prima facie, demonstration that a breach of fiduciary duty occurred.[11] In such cases the burden shifts onto the company’s management to show that a challenged transaction is intrinsically fair.[12]

Direct and derivative suits. Any party, including a shareholder or other equity owner of a business entity, may bring a direct suit against the entity where his particular interests have been harmed by some act of the business entity (for example, if there has been a breach of contract between such a party and the business). Some claims, however, may only be brought as derivative suits. A derivative suit is a lawsuit brought by a shareholder or other equity holder against a third party on the business entity’s behalf. Very often, this is a claim brought against an officer or director (or group of officers or directors) for some type of mismanagement. Plaintiffs generally prefer to bring their claims as direct claims, since the damages will go to them (the damages awarded in a derivative suit go to the corporation or other business entity). But claims involving a wrong against the equity holders generally (and not just the complaining party) are usually derivative in nature.[13]

A derivative action has strict requirements; failure to comply with these may lead to the dismissal of the suit. A plaintiff must: (1) be or have been a shareholder or equity holder of record at the time of the complained-of event[14]; and (2) either make a demand on the management to initiate the desired action, which demand was refused, or else show that such a demand is futile (because, for example, the entire management is complicit).[15] In settlements involving a derivative action, the court usually has to give its approval.

Capitalization. Capital is the minimum amount of value that will be kept in the business entity. This amount may be subject to legal restrictions set by state law.[16] Generally the amount of capital is, subject to such restrictions, set (and increased or decreased) by the board of directors or other governing body.[17]Capital surplus is the term used for the company’s value in excess of the capital amount. Capital and capital surplus are important because they can be used to calculate the company’s net assets, or the amount by which the total assets of the company exceed the total liability:

Net Assets = Total Assets – Total Liabilities

Capital Surplus = Net Assets – Capital

20.3 Traditional Business Entities

Traditionally, the three main types of business entities were the sole proprietorship, general partnership, and corporation.

Sole proprietorship. A sole proprietorship is not really a business entity at all, but rather a business owned and operated by a single individual. There are no formalities required to create a sole proprietorship; one simply needs to begin engaging in a business activity. A sole proprietorship is a disregarded entity for tax purposes; that is, it does not file its own tax return but rather reports its income as part of its owner’s tax filings. The owner of a sole proprietorship does not enjoy limited liability.

General partnership. A general partnership is an organization formed between two or more parties who share control, profits, losses, and property. General partnerships are subject to pass-through taxation; the partnership normally files a tax return but does not pay taxes itself. Instead, taxes are allocated to the partners in proportion to their share of the income. As with a sole proprietorship, there is no formality required to create a general partnership; such a relationship can exist even where the parties did not intend it. The great drawback to a general partnership is that it offers no limits on liability; thus, partners are personally liable for business debts.

Corporation. A traditional corporation (or “Subchapter C Corporation,” after the relevant section of the Internal Revenue Code) is a type of entity owned by holders of shares of stock (called shareholders or stockholders). There may be different classes of stock with different rights and privileges. Shareholders do not manage the company directly, but rather elect a board of directors to represent their interests and manage the company; in turn, the directors typically appoint officers to manage the day-to-day operations. Corporations are closely regulated by statute and involve corporate formalities, such as the requirement in most jurisdictions that a corporation hold an annual shareholders’ meeting. Shareholders may sell their some or all of their shares unless restricted by contract, leading to the creation of stock exchanges where such shares are bought and sold (indeed, all companies whose ownership interests are publicly traded on such exchanges must be corporations). Corporations may also pay dividends, or payments based on their profits, to some or all of their shareholders as determined by applicable law and the board of directors. Corporations are subject to corporate income taxation; in addition to paying tax on their own income, shareholders also must pay tax (either income or capital gains tax) on their dividends or proceeds from sale of their stock. The great advantage of corporations is that they afford limited liability to their shareholders, directors, and officers.

20.4 Alternative Business Entities

The traditional business entities each offer advantages and disadvantages. For example, general partnerships have the advantage of pass-through taxation, but lack the limited liability protection of partnerships. Beginning in the late nineteenth and continuing throughout the twentieth century, new types of business entities were developed that attempted to combine the best features of each. Not all types of alternative business entities are recognized in every jurisdiction. The following are the main types of alternative business entities.

“S” corporations. “S” corporations (named after Subchapter S of the Internal Revenue Code) are similar to corporations in matters of ownership and governance, but enjoy partnership-type pass-through taxation. There are, however, severe limitations which make “S” corporations inappropriate for most businesses. Only one class of stock is permitted, and ownership is limited to 100 owners, each of whom must be individuals (or individually-owned trusts) and all of whom must be either US citizens or permanent residents.

Benefit Corporations. Benefit corporations are a relatively new corporate form that has already been adopted in more than half of the states and the District of Columbia. They are for-profit enterprises whose directors are permitted (and indeed may be required) to consider social benefit (for example, social welfare or environmental considerations) in addition to profit in their decisions. Many benefit corporation statutes, including the Model Legislation adopted by some states, have been criticized for (among other things) their vagueness as to the duties of directors and other corporate managers vis a vis shareholders and the general public. As one commentator noted regarding the Model Legislation:

The Model requires directors to “consider” seven different stakeholder groups (§301(a)), and directs them to pursue “general public benefit” but does not provide any priorities to guide directors. (§§ 102, 201(a)). The Model allows companies to choose one of more “specific public benefit purposes,” in addition to the “general public benefit purpose,” but does not require that any specific public benefit purpose be chosen. (§ 201(b)).[18]

Some states, such as Delaware, have adopted more specific guidelines for their public benefit corporations:

In contrast, Delaware’s proposal does require public benefit corporations (“PBCs”) to choose one or more specific public benefits (§ 362(a)), though the statute is not crystal clear on priorities and requires directors to “manage or direct the business and affairs of the public benefit corporation in a manner that balances [1] the pecuniary interests of the stockholders, [2] the best interests of those materially affected by the corporation’s conduct, and [3] the specific public benefit or public benefits identified in its certificate of incorporation.” (§ 365(a)) (emphasis added). (As a side note, the PBC’s requirement to “balance” the stakeholder interests seems more onerous than the Model’s requirement to “consider” the interests.)[19]

Nevertheless, public benefit corporation statutes are often criticized on the grounds that they fail to clearly define priorities for the directors (specifically, to prioritize between the directors' duty to maximize shareholder utility and their duty to advance the social benefit for which the corporation was intended). In short, public benefit corporations fall within a new and still-developing area of law, one fraught with uncertainty for their directors and other decision-makers.

Limited partnerships. Limited partnerships (LPs) are formed by filing a certificate of limited partnership with the domicile’s Secretary of State or similar officer. They are “creatures of contract” and the partners are allowed great flexibility in terms of governance and finances. Like general partnerships, they offer pass-through taxation. General partnerships are managed by general partners, but may also have limited partners who share profits and losses but do not directly manage the company. Limited partners enjoy limited liability while general partners do not.

Limited liability companies. Limited liability companies (LLCs) have become the most popular form for new businesses in recent years. A limited liability company is extraordinarily flexible; generally, its owners (called “members”) may organize and manage the company in any way that they wish. Some LLCs are managed by managers, who may or may not be members, while others are directly governed by the members. LLCs may choose to have only one manager in most jurisdictions. LLCs are usually taxed as partnerships, but may (in the rare cases where it is advantageous) opt for corporation-style taxation. Many states permit certain “professionals”—such as accountants, attorneys, dentists, and doctors—to form LLCs. Some states, however, require that these types of professionals form Professional Limited Liability Companies (PLLCs) to perform their “professional services.”[20] PLLCs are substantially similar business entities to LLCs.

Series LLCs. Series LLCs are an innovative form of alternative entity in which in which multiple "series" are incorporated into a single limited liability company. Each series can have different ownership and management structures and own different assets. The various series are, at least in theory, protected from liabilities incurred by other series within the company. The series LLC was first enacted in Delaware[21] but has since been adopted in a number of other states.[22] The series LLC can be an attractive option when a single economic entity owns a large number of segregable assets, resulting in lower franchise tax, filing fees, administrative expenses, and other costs that, in the aggregate for multiple entities, could be considerable. Nevertheless, questions have been raised whether states lacking a series LLC statute will give full faith and credit to the liability protections afforded to such entities in their domicile jurisdiction. States that have series LLC legislation typically will honor the protections afforded by other states' statutes, but the situation is far from clear in jurisdictions that have not authorized series LLCs domestically.

Business trusts. Business trusts are organized in the same manner as common-law trusts (which are usually used as estate planning and wealth management tools for individuals). Ownership interest is held by beneficial owners who enjoy similar rights and responsibilities as beneficiaries of a common-law trust, in particular, the right to profits earned from the company’s property. Management is carried out by trustees who hold the right of control over the property. Traditionally, such entities were formed under common law (as, for example, so-called “Massachusetts business trusts”) and were not registered with the government. In recent years, a number of states have codified statutes authorizing the formation of statutory trusts (such as the increasingly-popular Delaware Statutory Trust or DST) that offer limited liability protection for both trustees and beneficial owners.

Limited Liability Partnerships (LLP) and Limited Liability Limited Partnerships (LLLP). Many states allow for other types of alternative business entities, though few businesses opt to organize in these ways. Some of the rarer forms of business entity include limited liability partnerships (most of which are accounting or law firms), in which the partners are personally liable for their own malpractice but not that of their partners. Limited liability limited partnerships (structured like a limited partnership but with LLP-style liability protection for general partners) also exist in some jurisdictions.

[6] In addition to documents governing the management of a company, the law of most states permits shareholder agreements (sometimes called voting trusts) that control some or all of the stock (or other equity interests) of a company and that requires the owners of such encumbered shares to vote in certain ways or to refrain from taking certain actions. These agreements can be used to establish voting blocs, to restrict or even forbid the transfer or sale of one’s interest in the company, or require certain compositions for the board of directors or other managing body. See, e.g., 8 Del. C. § 202 (regulating restrictions on the transfer of securities).